SBP cuts policy rate to a single digit

Karachi: The State Bank of Pakistan (SBP) has cut its policy rate by 50 basis points to bring it down from 10 percent to 9.5 percent with effect from 17th December, 2012. This was decided by the Central Board of Directors of the State Bank of Pakistan at its meeting held under the chairmanship of SBP Governor, Yaseen Anwar in Karachi today.

According to the Monetary Policy Decision, the decline in CPI inflation is considerably faster than earlier estimates. The year-on-year CPI inflation for November 2012 stands at 6.9 percent, with food inflation dropping to 5.3 percent and non-food inflation coming down to 8.1 percent. Even the core inflation measures are in single digits. This broad based deceleration in inflation is now expected to keep the average inflation for FY13 below the 9.5 percent target for the year. Therefore, the Central Board of Directors of SBP has decided to reduce the policy rate by 50 basis points to 9.5 percent with effect from 17 December 2012.

‘ The changes in fundamental variables influencing the recent monetary policy decisions of SBP continue to support the current stance. The credit extended to private businesses remains muted. The deceleration in CPI inflation is faster than the projected path. And the external current account deficit in October 2012 is small. The overall stress in the external position, however, is increasing given the declining financial inflows and substantial debt repayments.

Assigning appropriate weights to these competing considerations is the main challenge currently faced by monetary policy. Led by direct and portfolio investment flows, the total net capital and financial account inflows are on a declining path for some years now. For instance, these inflows have come down from a peak of 7.2 percent of GDP in FY07 to 0.7 percent of GDP in FY12. This trend is continuing in FY13. During the first four months, there has been a net outflow of $304 million from the capital and financial account. This, together with substantial debt repayments to the IMF, has resulted in a decline in foreign exchange reserves of SBP from $10.8 billion at end-June 2012 to $8.6 billion as on 14 December 2012. Thus, despite an external current account surplus of $258 million during July-October, FY13, there has been some pressure on the rupee to depreciate. Since the beginning of FY13, the rupee, viz-a-viz dollar, has depreciated by 3.3 percent.

This stressed external position has implications for the rest of the economy. For instance, the decline in foreign exchange reserves is causing contraction in rupee liquidity. A depreciating currency is also affecting the size of the outstanding external debt in rupee terms and thus has implications for the fiscal position. Moreover, the magnitude and speed of pass through of exchange rate changes to CPI inflation need to be monitored closely in these circumstances.

Both the level of interest rate set by the SBP and the timely realization of budgeted foreign inflows are critical in managing the balance of payment position. The lower interest rate can potentially affect the credit demand, including that of imports, and return on rupee denominated assets relative to foreign currency assets. The first consideration is not a source of concern at the moment given the weak overall credit conditions and consistent decline in the quantum of imports. The second consideration is important and puts a natural limit on downward adjustments in the interest rate. However, it needs to be weighed against the expected budgeted foreign inflows, which are not linked with the interest rate but can boost much needed financial inflows.